Commentary on Political Economy

Thursday, 21 June 2018

The Chinese Dictatorship’s Belt and Road to Nowhere

Perhaps the greatest ominous sign of the tremendous crisis that is about to hit global capitalism - in line with what we argued in our previous post - is the desperate convulsive attempt by the Chinese Dictatorship to keep its command economy afloat through imperialist (and racist) expansion abroad. This attempt is already failing. Here is an extract from a recent post in the Wall Street Journal that summarises the unfailing signs of the coming catastrophe:

While the sell-off in currencies of emerging markets with insufficient foreign exchange (forex) reserves and wide current account deficits — such as the Argentine peso and the Turkish lira — is still picking up steam, there is relative calm in China. The yuan is trading well off its recent multi-year lows.

On the surface, the yuan has plenty of forex reserves (over $3 trillion) and its current account has been in surplus for over 20 years. But under the surface, it very well may have some serious issues.

The natural question is: If there is no need for external financing, why did China lose $1 trillion in forex reserves between mid-2014 and mid-2016 before briefly arresting that decline? The decline has now resumed (see chart).

Danger for China

There is a bonfire burning in the Chinese financial system because the bulk of rampant dollar borrowing in emerging markets in the past 10 years has come from China, because of the sheer size of the Chinese economy, which was $11.94 trillion in 2017 — second largest in the world. Furthermore, unlike in India where GDP growth is driven by self-sustainable internal domestic demand, in China GDP growth is driven by accelerating dollar borrowing (see chart) and aggressive mercantilist tactics.

Chinese over-leverage

Furthermore, unlike in India where GDP growth is driven by self-sustainable internal domestic demand, in China GDP growth is driven also by accelerating yuan borrowing. As Chinese GDP has grown 12-fold over 20 years, its total financial leverage has grown over 40-fold. That means the GDP-to-total-debt ratio in China has grown by a factor of nearly 4 times. Such estimates include shadow banking leverage, which is excluded from all official figures, but by estimates from credible sources including the Brookings Institution is as large as the official Chinese economy (see report).

If a trade war were to escalate, the fragile balance in the Chinese economy could be tipped and we may very well experience a second Asian crisis, which ironically, was also driven by rampant dollar borrowing. The important difference here would be that China’s GDP is many times larger than the total GDP of all countries involved in the first Asian crisis in 1997-1998 (when China’s GDP was barely above $1 trillion).

While the sell-off in the Turkish lira and Argentine peso is generating headlines at the moment, it is hard for the Chinese yuan to get the same attention as there are still plenty of forex reserves to stop the yuan from depreciating further. One could say that because of the bigger war chest of the People’s Bank of China, the yuan is not necessarily a similar market indicator to other emerging markets currencies whose central banks are in considerably less fortunate positions.

The key here remains forex reserve outflows, in which a pickup similar to what we saw in 2015 after the crash of the Shanghai Composite (and faster than the present pace) would be the major red flag.

Other market-driven indicators

The Shanghai Composite Index SHCOMP, +0.27% has fallen this week already to as low as 2,907 points. It sure looks to have experienced a bad “crack” in 2018. I have previously referred to the rally off the January 2016 lows of 2,650 as “the mother of all dead cat bounces,” or MOADCB, a bear market rally that could not recover in two years what it lost in a single month (January 2016). The index is now unwinding that MOADCB rather expeditiously (see chart).

I am aware that the Shanghai Composite is not as good a reflection of the Chinese economy as India’s Sensex is for the economy of India, as China’s economic growth does not necessarily translate into profit growth due to the much bigger government intervention in the economy in the best interest of “social stability,” as the Chinese like to say. Still, the troubling developments in the Shanghai Composite cannot be ignored when forex reserve flows have resumed and there is a rather unconventional man at the wheel of a kerosene truck headed for the blazing bonfire of the Chinese financial system.